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Reserve Bank of India: Working and Functions

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RBI-Tower in Mumbai

Reserve Bank of India is India's central bank, headquartered at Bombay. Central bank of a country execute multiple functions such as overseeing monetary policy, issuing currency, managing foreign exchange, working as a bank of government and as banker of scheduled commercial banks, etc. It also works for overall economic growth of the country. The Reserve Bank of India was established in 1935 with the provision of Reserve Bank of India Act, 1934.[1] Though privately owned initially, it was nationalised in 1949 and since then fully owned by Government of India (GoI). The preamble of the Reserve Bank of India describes it main functions as:

..to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.

Issuer of Currency

Reserve bank of India is the sole body who is authorized to issue currency in India. While coins and one rupee notes are minted by Government of India (GoI), the RBI works as an agent of GoI for distributing and handling of coins. RBI also works to prevent counterfeiting of currency by regularly upgrading security features of currency. For printing currency, RBI has four facilities at Dewas, Nasik, Mysore and Salboni. The RBI is authorized to issue notes up to value of Rupees ten thousands and coin up to one thousands. New notes of Rupees 500 and 2000 have been issued on 8th Nov 2016 . The old series note of Rupees 1000 and 500 are considered illegal and just paper from midnight on 8 November 2016. Earlier 1000 notes have been discarded by RBI.

Exchanging old notes

People gathered at ATM of Axis Bank in Mehsana, Gujarat to withdraw cash following deposit of demonetised currency notes in bank on 15 November 2016.

The Reserve Bank of India laid down a detailed procedure for the exchange of the demonetised banknotes with new ₹500 and ₹2,000 banknotes of the Mahatma Gandhi New Series and ₹100 banknotes of the preceding Mahatma Gandhi Series. Following are the key points:

Long queue in front of SBI ATM at Paravur near the city of Kollam in Kerala, 19th November 2016.
  • Citizens will have until 30 December 2016 to tender their old banknotes at any office of the RBI or any bank branch and credit the value into their respective bank accounts.
  • Cash withdrawals from bank accounts were restricted to ₹10,000 per day and ₹20,000 per week per account from 10 to 13 November 2016. This limit was increased to ₹24,000 per week from 14 November.[2][3]
  • For immediate cash needs, the old banknotes could be exchanged for the new ₹500 and ₹2,000 banknotes as well as ₹100 banknotes over the counter of bank branches by filling up a requisition form along with a valid ID proof. It was announced that this facility would be available until 30 December 2016.
    • Initially, the limit was fixed at ₹4,000 per person from 8 to 13 November 2016.
    • This limit was increased to ₹4,500 per person from 14 to 17 November 2016.[2][3]
    • The limit was reduced to ₹2,000 per person from 18 November 2016.[4]
    • All exchange of banknotes was abruptly stopped from 25 November 2016.[5]
  • Initially, all ATMs were dispensing banknotes of only ₹50 and ₹100 denominations and cash withdrawals from ATMs were restricted to ₹2000 per day.[6] From 14 November onwards, ATMs recalibrated to dispense new ₹500 and ₹2000 notes will allow a maximum withdrawal of ₹2,500 per day, while other ATMs dispensing banknotes of only ₹50 and ₹100 denominations will allow a maximum withdrawal of ₹2000 per day.[2][3]

However, exceptions were given to petrol, CNG and gas stations, government hospitals, railway and airline booking counters, state-government recognised dairies and ration stores, and crematoriums to accept the old ₹500 and ₹1,000 banknotes until 11 November 2016, which was later extended to 14 November 2016 and once again to 24 November 2016.[7][8] International airports were also instructed to facilitate an exchange of notes amounting to a total value of ₹5,000 for foreign tourists and out-bound passengers.[9]

Under the revised guidelines issued on 17 November 2016, families were allowed to withdraw ₹250,000 for wedding expenses from one account provided it was KYC compliant. The rules were also changed for farmers who are permitted to withdraw ₹25,000 per week from their accounts against crop loan.[4][10]

Cash Crunch and effects

Queue at an ATM for ₹100 banknotes in Howrah, on 8 November 2016, 22:23 (IST)
People queue outside a private bank to deposit and exchange old ₹500 and ₹1000 banknotes in Kolkata on 10 November 2016.

The scarcity of cash due to demonetisation led to chaos, and most people holding old banknotes faced difficulties exchanging them due to endless lines outside banks and ATMs across India, which became a daily routine for millions of people waiting to deposit or exchange the ₹500 and ₹1000 banknotes since 9 November.[11][12][13][14] ATMs were running out of cash after a few hours of being functional, and around half the ATMs in the country were non-functional.[12] Sporadic violence was reported in New Delhi, but there were no reports of any grievous injury,[15] people attacked bank premises and ATMs,[16][17][18][19][20][21] and a ration shop was looted in Madhya Pradesh after the shop owner refused to accept ₹500 banknotes.[22][23][24][25]

Banker and Debt Manager to Government

Just like individuals need a bank to carry out their financial transactions effectively & efficiently, Governments also need a bank to carry out their financial transactions. RBI serves this purpose for the Government of India (GoI). As a banker to the GoI, RBI maintains its accounts, receive payments into & make payments out of these accounts. RBI also helps GoI to raise money from public via issuing bonds and government approved securities.

Banker's bank and supervisor

RBI also works as banker to all the scheduled commercial banks. All the banks in India maintain accounts with RBI which helps them in clearing & settling inter bank transactions and customer transactions smoothly & swiftly. Maintaining accounts with RBI help banks to maintain statutory reserve requirements. RBI also acts as lender of last resort for all the banks.

Regulator of the Banking System

RBI has the responsibility of regulating the nation's financial system. As a regulator and supervisor of the Indian banking system it ensures financial stability & public confidence in the banking system. RBI uses methods like On-site inspections, off-site surveillance, scrutiny & periodic meetings to supervise new bank licenses, setting capital requirements and regulating interest rates in specific areas. RBI is currently focused on implementing Basel III norms.

Manager of Foreign Exchange

With increasing integration of the Indian economy with the global economy arising from greater trade and capital flows, the foreign exchange market has evolved as a key segment of the Indian financial market and RBI has an important role to play in regulating & managing this segment. RBI manages forex and gold reserves of the nation.

On a given day, the foreign exchange rate reflects the demand for and supply of foreign exchange arising from trade and capital transactions. The RBI’s Financial Markets Department (FMD) participates in the foreign exchange market by undertaking sales / purchases of foreign currency to ease volatility in periods of excess demand for/supply of foreign currency.

Regulator and Supervisor of the Payment and Settlement Systems

Payment and settlement systems play an important role in improving overall economic efficiency. The Payment and Settlement Systems Act of 2007 (PSS Act)[26] gives the Reserve Bank oversight authority, including regulation and supervision, for the payment and settlement systems in the country. In this role, the RBI focuses on the development and functioning of safe, secure and efficient payment and settlement mechanisms. Two payment systems National Electronic Fund Transfer (NEFT) and Real Time Gross Settlement (RTGS) allow individuals, companies and firms to transfer funds from one bank to another. These facilities can only be used for transferring money within the country.

NEFT operates on a deferred net settlement (DNS) basis and settles transactions in batches. The settlement takes place for all transactions received till a particular cut-off time. It operates in hourly batches — there are 12 settlements from 8 am to 7 pm on weekdays and SIX between 8 am and 1 pm on Saturdays.[27] Any transaction initiated after the designated time would have to wait till the next settlement time. In RTGS, transactions are processed continuously, all through the business hours. RBI’s settlement time is 9 am to 4:30 pm on weekdays and 9 am to 2:00 pm on Saturdays.[28]

Developmental Role

This is one of the most critical role RBI plays in building the country's financial structure. Key tools in this effort include Priority Sector Lending such as agriculture, micro and small enterprises (MSE), housing and education. RBI work towards strengthening and supporting small local banks and encourage banks to open branches in rural areas to include large section of society in banking net.

Monetary Policy

Monetary Policy refers to the process employed by Central bank of the country to control availability & cost of currency and thus keeping Inflation & Deflation low and stable. The central bank does so by using various tools. Broadly these tools can be categorized in two parts as Quantitative & Qualitative tools.

Quantitative Tools

Quantitative tools refer to reserve ratio ,slr, crr etc

Reserve Ratio

Reserve ratios are the share of net demand & time liabilities (NDTL) which banks have to keep aside to ensure that they have sufficient cash to cover customer withdrawals. There are two types of reserve ratios.

Statutory Liquidity Ratio (SLR)

The share of net demand and time liabilities that banks must maintain in safe and liquid assets, such as government securities, cash and gold. The present SLR is 19.5%. [29]

Cash Reserve Ratio (CRR)

The share of net demand and time liabilities that banks must maintain as cash with RBI. The RBI has set CRR at 4%. 1% change in it today affects the economy with Rs. 96000 crores. An increase sucks this amount from the economy, while a decrease injects this amount into the economy.So if a bank has 200 Crore of NDTL then it has to keep Rs. 8 Crore in cash with RBI. RBI pays no interest on CRR.

Let's assume economy is showing inflationary trends & RBI wants to control this situation by adjusting SLR & CRR. If RBI increases SLR to 50% and CRR to 20% then bank will be left only with Rs. 60 crore for operations. Now it will be very difficult for bank to maintain profitability with such small capital. Bank will be left with no choice but to raise interest rate which will make borrowing costly. This will in turn reduce the overall demand & hence price will come down eventually.

Open Market Operation (OMO)

Open market operation is the activity of buying and selling of government securities in open market to control the supply of money in banking system. When there is excess supply of money, central bank sells government securities thereby sucking out excess liquidity. Similarly, when liquidity is tight, RBI will buy government securities and thereby inject money supply into the economy.

Policy Rates

Policy rates are various interest rate which RBI uses to control money supply in India. Repo Rate is often called as key policy rate in India as all the other rates can be derived from repo rate.

Bank Rate

When banks want to borrow long term funds from RBI, it is the interest rate which RBI charges to them. It is currently set to 6.25%[30](Fourth Bi-monthly Monetary Policy Statement, 2017–18). The bank rate is not used to control money supply these days. Although penal rates are linked to bank rate. If a bank fails to keep SLR or CRR then RBI will impose penalty & it will be 300 basis points above bank rate.

Liquidity Adjustment Facility (LAF)

Liquidity Adjustment facility was introduced in 2000. LAF is a facility provided by the Reserve Bank of India to scheduled commercial banks to avail of liquidity in case of need or to park excess funds with the RBI on an overnight basis against the collateral of Government securities. RBI accept application for a minimum amount of Rs.5 crore and in multiples of Rs. 5 crore thereafter. LAF enables liquidity management on a day-to-day basis. The operations of LAF are conducted by way of repurchase agreements called Repos & Reverse Repos.

Repo Rate

If banks want to borrow money (for short term, usually overnight) from RBI then banks have to charge this interest rate. currently, Repo rate is set to 6% w.e.f 9 August 2017. Banks have to pledge government securities as collateral. This kind of deal happens through a re-purchase agreement. If a bank wants to borrow Rs. 100 crores, it has to provide government securities at least worth Rs. 100 crore (could be more because of margin requirement which is 5%-10% of loan amount) and agree to repurchase them at Rs. 106.75 crore at the end of borrowing period. So the bank has paid Rs. 6.75 crore as interest. This is the reason it is called repo rate. The government securities which are provided by banks as collateral can not come from SLR quota (otherwise the SLR will go below 19.5% of NDTL and attract penalty). Banks have to provide these securities additionally.

To curb inflation, RBI increases Repo rate which will make borrowing costly for banks. Banks will pass this increased cost to their customers which make borrowing costly in whole economy. Fewer people will apply for loan and aggregate demand will get reduced. This will result in inflation coming down. RBI does the opposite to fight deflation. Although when RBI reduce Repo rate, banks are not legally required to reduce their base rate.

Reverse Repo Rate

As the name suggest, reverse repo rate is just the opposite of repo rate. If a bank has surplus money, they can park this excess liquidity with RBI and central bank will pay interest on this. This interest rate is called reverse repo rate & it is now 25 basis points (post April 2016) below repo rate. At present, reverse repo rate is 5.75%. Fourth Bi-monthly Monetary Policy Statement, 2016–17

Marginal Standing Facility (MSF)

This scheme was introduced in May, 2011 and all the scheduled commercial bank can participate in this scheme. Banks can borrow up to 2.5%[31] percent of their respective Net Demand and Time Liabilities. RBI receive application under this facility for a minimum amount of Rs. One crore and in multiples of Rs. One crore thereafter. The important difference with repo rate is that bank can pledge government securities from SLR quota (up to one percent). So even if SLR goes below 20.5%(RBI/2014-15/445 DBR.Ret.BC.70/12.02.001/2014-15, dt. 16.10.2016) by pledging SLR quota securities under MSF, bank will not have to pay any penalty. The MSF rate is set to 100 basis point above bank rate and currently is at 6.50% as of 1.6.17.[32][better source needed]

Qualitative Tools

Margin Requirements or LTV

Loan to Value is the ratio of loan amount to the actual value of asset purchased. RBI regulates this ratio so as to control the amount bank can lend to its customers. For example, if an individual wants to buy a car from borrowed money and the car value is Rs. 10 Lac, he can only avail a loan amount of Rs. 7 Lac if the LTV is set to 70%. RBI can decrease or increase to curb inflation or deflation respectively.

Selective credit control

Under this measure, RBI can specifically instruct banks not to give loans to traders of certain commodities e.g. sugar, edible oil etc. This prevents speculations/ hoarding of commodities using money borrowed from banks.

Moral Suasion

Under this measure RBI try to persuade bank through meetings, conferences, media statements to do specific things under certain economic trends. For example, when RBI reduces repo rate, it asks banks to reduce their base rate as well. Another example of this measure is to ask banks to reduce their Non-performing assets (NPAs).

Limitations of Monetary Policy

In developing countries like India, Monetary Policy fails to show immediate or no results because of below factors:

  1. People do not employ alternative investment options. A large section of society still depends on saving accounts, fixed deposits, Public Provident Fund for investment. Commercial banks have large deposits. RBI is not the main or even prominent money supplier for these banks. So whatever monetary action central bank takes has little or late impact on the economy.
  2. Many people in rural areas are out of banking net and whatever RBI does has no impact on their financial activities.
  3. Monsoon uncertainty adversely affects food production and thereby cause food inflation. Monetary Policy has no impact on food inflation.

References

  1. ^ http://www.rbi.org.in/scripts/OccasionalPublications.aspx?head=Reserve%20Bank%20of%20India%20Act
  2. ^ a b c "Finance Ministry has reviewed the position regarding availability and distribution of all denominations of bank notes" (PDF). Ministry of Finance, Government of India. Retrieved 13 November 2016.
  3. ^ a b c "Withdrawal of Legal Tender Character of existing ₹ 500/- and ₹ 1000/- Bank Notes – Revision in limits". Reserve Bank of India. Retrieved 13 November 2016.
  4. ^ a b "The Central Government takes several decisions to facilitate farmers, small traders, Group 'C' Employees of Central Government including equivalent levels in the Defence and Para Military Forces, Railways and Central Public Sector Enterprises in the aftermath of the cancellation of the legal tender character of the old Rs. 500 and Rs. 1000 notes; Also decides to reduce the limit of exchange of old Rs. 500/- and Rs. 1000/- notes across the counter in banks from Rs. 4500/- to Rs. 2000/-with effect from 18th November, 2016" (PDF). Ministry of Finance, Government of India. Retrieved 17 November 2016.
  5. ^ http://indianexpress.com/article/india/india-news-india/pm-modi-said-exchange-limit-to-be-hiked-after-november-24-exchange-stopped-4393985/
  6. ^ "ATMs –Non-dispensing of Old High Denomination Notes – Closure of operations". Reserve Bank of India. 8 November 2016. Retrieved 8 November 2016.
  7. ^ "Govt extends old notes exemption deadline to midnight Nov 24". The Hindu. Retrieved 14 November 2016.
  8. ^ "FAQs on Withdrawal of Legal Tender Character of the existing Bank Notes in the denominations of ₹ 500/- and ₹ 1000/-". Reserve Bank of India. Retrieved 13 November 2016.
  9. ^ "Outlets that will accept Rs 1,000 and Rs 500 notes in next 72 hours". The Economic Times. 8 November 2016. Retrieved 9 November 2016.
  10. ^ "Demonetisation rule modified, families can withdraw Rs 2.5 lakh for weddings from one account". India Today. 17 November 2016. Retrieved 17 November 2016.
  11. ^ "India demonetisation: Chaos as ATMs run dry". Al Jazeera. Retrieved 9 November 2016.
  12. ^ a b "Demonetisation: Chaos grows, queues get longer at banks, ATMs on weekend". 12 November 2016.
  13. ^ "India: Demonetisation takes its toll on the poor". Al Jazeera. 16 November 2016. Retrieved 17 November 2016.
  14. ^ "Queues get longer at banks, ATMs on weekend". The Hindu. 12 November 2016.
  15. ^ "Demonetisation: Sporadic violence in Delhi, cops receive 4.5K calls". New Indian Express.
  16. ^ "Unrest erupts in UP towns as cashless crowds vent ire on bank staff – Times of India". Retrieved 24 November 2016.
  17. ^ "In western UP, violence marks day 13 of demonetisation – Times of India". Retrieved 24 November 2016.
  18. ^ "Demonetisation effect: ATM vandalism on rise". 18 November 2016. Retrieved 24 November 2016.
  19. ^ "Demonetisation: Angry customers break bank's glass door in Kollam". The Indian Express. 12 November 2016.
  20. ^ Reporter, Staff (13 November 2016). "No cash: 'frustrated' man smashes ATM glass wall". The Hindu.
  21. ^ "Hid in Washroom For an Hour: Official After Attack at IDBI Bank".
  22. ^ "Villagers loot fair price shop after dealer refuses scrapped banknotes". Hindustan Times. 12 November 2016.
  23. ^ "Nerves snap in long cash wait, shop looted".
  24. ^ "Villagers looted ration shops in Madhya Pradesh after the shop owner refused to accept old notes".
  25. ^ "Demonetisation Fallout: Cashless Villagers Loot PDS Shop in MP's Chhatarpur Village". 12 November 2016.
  26. ^ http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/86706.pdf
  27. ^ http://www.rbi.org.in/scripts/FAQView.aspx?Id=60
  28. ^ http://www.rbi.org.in/scripts/FAQView.aspx?Id=65
  29. ^ http://www.rbi.org.in/home.aspx
  30. ^ http://rbidocs.rbi.org.in/rdocs/Wss/DOCs/5T_08121744615763C4DE4D6F9DC464E9EB70E7B4.XLSX
  31. ^ https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=8248&Mode=0
  32. ^ Monetary policy of India
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